The Sixth Turning Is Here
The recession is back on, baby.
At least that’s the message that some are concluding from surging oil prices, a strengthening dollar, and a jaw-dropping rise in interest rates. We’ve gone from everyone patting themselves on the back about achieving a “soft landing” to fears that the economy will significantly contract next year.
The vibe shift was captured nicely in a column by Mohamed El-Erian that was published Thursday in the Financial Times under the headline “The U.S. may no longer avoid a recession”:
An intense period of rising interest rates, high oil prices and a stronger dollar is pushing the financial market consensus on US economic growth away from the comforting notion of a soft landing.
By my count, this will be the sixth time in the past 15 months that conventional wisdom shifts for the world’s most influential economy. It is a pivot that, unfortunately, is likely to stick for longer this time around, threatening what has been an impressively strong US economy, undermining genuine financial stability and exporting volatility to the rest of the world.
In just the last two weeks, the yield on the benchmark US 10-year bond has risen by some 0.5 percentage points to around 4.8 per cent as part of a comprehensive shift in the entire interest rate structure. The move brought the change in yields to an eye-popping 1 percentage point since the end of June, leading to higher borrowing rates for companies, more burdensome car loans for households, and more pronounced and uneven deposit outflows from the banking system as investors shift cash into money market accounts. And notably, the cost of a 30-year mortgage is about to top 8 per cent, making already expensive home purchases even less affordable.
There is admittedly an appealing logic in this argument. Increasing borrowing costs should be expected to weigh down business investment and home price appreciation. Household purchases for big-ticket durable goods that need to be financed—cars and trucks, for example—can be expected to slow. Banks could face financing strains from deposit outflows that could cause them to pull back from lending.
Another Market Mistake?
Yet it is also a very odd logic. If the economy is hurtling toward a recession, bond prices should be rising—and yields falling—in anticipation of a Federal Reserve rate cut. Investors should be engaged in a “flight to safety” of bonds. The fact that we are seeing yields rise rapidly on longer-maturity bonds would seem to indicate that investors increasingly anticipate stronger growth than they did when yields are lower.
Traders work on the floor of the New York Stock Exchange during morning trading on October 4, 2023, in New York City. (Michael M. Santiago/Getty Images)
The odds implied by the market in federal funds futures—derivatives that allow investors to hedge or speculate on changes in the Federal Reserve’s target rate—are around 96 percent that the Fed will ease sometime next year. That’s very close to what they were a week ago and slightly less than month ago. A month ago, however, the rate cut expectation was based on the view that the Fed will defeat inflation without much damage to the economy. Now it appears to be based on the idea that the Fed will have to cut because of a slumping economy.
You almost have to admire the conviction that a Fed cut is coming next year no matter what. If the economy experiences a soft landing, the Fed will cut because inflation has gone away and restrictive monetary is no longer required. If the economy experiences a hard landing, the Fed will cut because growth is slumping.
A far simpler interpretation of rising interest rates is that the bond market is now reflecting a more bullish view of the economy. And why shouldn’t it?
The Birthing of a Rough Beast
Growth appears to have accelerated in the third quarter of this year even after out-performing expectations in the first half of the year. Home prices are rising despite the highest mortgage rates in years, an outcome almost no one saw coming, creating a wealth effect that facilitates more consumer spending. The shortage of existing homes on the market that are fueling the price rise is also fueling home building, which has a big multiplier effect on the economy by boosting employment and purchases of both materials and durable goods like appliances.
But won’t higher bond yields restrain growth? While that’s possible, whether higher rates tip us into below-trend growth depends on the underlying pace of growth. If the economic expansion was going to be robust, you would expect bond yields to rise just enough to pull growth back toward something more normal—but no more. Once bond yields exceeded the level necessary to bring growth back toward potential, they’d fall back down in anticipation of a stimulative cut from the Fed.
This does not mean we will not have a recession—just that it is unlikely to be triggered by a bond market tightening in the absence of further Fed tightening.
One scenario that seems to have been widely overlooked in today’s financial market is the possibility that growth continues into next year and inflation does not come down much further (or even begins to creep back up). This is the so-called “no landing” scenario. In this case, the Fed could be forced to raise rates even further in an effort to snuff out inflation. In the process, the Fed could trigger a recession. It does not seem all that unlikely that bringing down inflation to two percent will actually require a recession.
In other words, the most likely path down to two percent is not going to be “immaculate” at all. Instead, it will be a tumultuous affair full of error and interest.
